University of California, Los Angeles (UCLA); National Bureau of Economic Research (NBER)

Date Written: October 1, 2010

Abstract

In our model, financial firms’ leverage choices and asset sales impose externalities on other financial firms. This means that individual firms cannot determine their optimal capitalizations in isolation, but have to take the aggregate financial sector characteristics into account. They become more aggressive when their peers are more conservative. For large parameter regions, small parameter differences induce just mild differences in the equilibrium allocation of risk. However, going just a little further, they can also induce completely different equilibria. Historical experience is not necessarily a good guide as to whether the prevailing equilibrium is fragile or not.

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